Bond quality important in unsettled times

Lower interest rates increase their value

Government data, corporate earnings, loan defaults, retail sales figures and Federal Reserve decisions often produce more fog than clarity about the future.

Even former Fed Chairman Alan Greenspan contributed to this murky horizon. His book slams President Bush's lack of spending curbs and attributes the housing boom to lower long-term interest rates stemming from communism's fall. More important, he warns of the likelihood of higher rates in the future to thwart inflation.

The problem is it will take time to sort out what really matters -- namely who holds losses from the subprime lending debacle and the ultimate effect on balance sheets. It is a tall order to ask the Fed to energize the economy and markets.

This leaves investors wondering about the best strategy to employ for fixed-rate instruments. Indications are that lower interest rates are ahead, but just how low will depend on all those confusing numbers.

"With the economy looking to weaken, there is a greater probability that interest rates will be lower rather than higher," said Mario De Rose, chief fixed-income strategist with Edward Jones in St. Louis. "Demand for higher-quality bonds will be strong, and if we're going into a recessionary environment, you should pare back your high-yield bond positions."

Quality bonds rated AAA to AA, along with U.S. Treasuries, look best for investors right now, De Rose said. You won't have to worry about defaults, which typically increase as the economy slows.

"Don't abandon stocks, since you want them in your portfolio for potential growth," De Rose said. "But if we're moving toward greater risk in the economy, make sure you have a bond component in your portfolio."

Your portfolio should remain balanced between stocks, bonds and cash, he said.

"Though outright recession is not likely right now, the economy could slow significantly and impact fixed-rate portfolios," said Benjamin Gord, a portfolio manager for the Oppenheimer investment-grade bond team that manages $18 billion. "But I wouldn't move away from your existing bond-fund holdings that are broadly diversified just because of current events."

There is an outside chance of a surprise the other way, with the subprime fallout less than the market expects, Gord said.

Lower interest rates increase the value of existing bonds, while higher rates reduce their value. The longer the duration of bonds, the greater potential for volatility because of rate fluctuations. Many experts therefore advise a "ladder" of individual bonds or funds, some as short as one or two years in duration, others five to 10 years.

There's nothing wrong with basic fixed-rate investments, so long as you understand differences. For example, short- and intermediate-term bond funds yield more than money-market funds because they carry more risk.

"Right now, money markets have some very good rates, but they aren't locked in," said Marilyn Capelli Dimitroff, certified financial planner and president of Capelli Financial Services Inc. in Bloomfield Hills, Mich. "But we're also finding some good relative rates in certificates of deposit and U.S. Treasuries."

Examine your funds to see if they have complex holdings, she said. Examples would be mortgage-backed collateralized mortgage obligations and collateralized debt obligations, which could encounter more problems if the economy continues to slide.

"We prefer shorter-term bonds of higher quality because we view bonds as the 'air bag' of a portfolio," Capelli Dimitroff said. "Since bonds are never going to give you the potential return of stocks, it just doesn't seem a really great place to take risk."

In confusing times, a brand-name bond manager may be a good idea.

"For our client portfolios we're favoring our favorite bond-fund managers, such as Bob Rodriguez at FPA New Income Fund, who has never had a loss in 20 years of managing that fund," said Vern Hayden, certified financial planner with Hayden Financial Group LLC in Westport, Conn.

The $1.8 billion FPA New Income (FPNIX), up 5 percent over the past 12 months, is emphasizing intermediate-term bonds of one year in duration. That compares with three- to five-year durations of many intermediate funds.

Managed by Rodriguez since 1984, this conservative value-oriented fund pays little attention to the broad market index. It has a 3.5 percent "load" (sales charge) and requires a $1,500 minimum initial investment.

Hayden also is recommending to his clients the $14 billion Loomis Sayles Bond Fund (LSBRX), up 9 percent over the past 12 months.

Daniel Fuss, lead manager of the fund since 1991 and admirably its largest shareholder, is recognized as one of the top managers in the business. Be aware, however, that he invests in many different bond sectors and is willing to assume some risk through corporate bonds, emerging markets and currency plays. This "no-load" fund requires a $2,500 minimum initial investment.

Most fund families offer bond funds of short-, intermediate- and long-term bond durations, as well as varying credit quality.

"People are confused, and while we try to maintain a well-balanced portfolio just as everybody does, we've become even a little more conservative than usual lately," Hayden said. "Bond funds are playing a major defensive role for us."